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My previous article highlighted the advantages of investing in commercial second mortgages. All investing carries risk, but as my mentor Gordon Moss likes to say, “there are no bad notes, only bad prices.”

By investing in junior commercial notes, you can price according to your risk tolerance by taking into account some of these unique challenges.

Rational Borrowers: Negotiating with a rational person may seem like a great idea if you have any experience dealing with irrational homeowners, but it can be a double-edged sword. A borrower making an unemotional business decision about their debt may decide it is in their best interest to walk away or file bankruptcy. If you were in financial trouble and had to choose between getting your home or your investment property foreclosed on, which mortgage would you stop paying?

Unknown First Mortgage: If the borrower personally signed for the first mortgage, it may be on their credit report. And it may not. Commercial notes are often not reported on traditional credit reports. Without knowing the balance of the first mortgage, how will you know how much equity secures the second? The note seller may not have written authorization or access to information about the first mortgage.

You can ask, but without this information from credit or the seller, your best source of data may be checking title to see what the balance of the first mortgage was at the time of origination and whether the first lender has initiated foreclosure. Also check Public Access to Court Electronic Records (PACER) to see whether the business owner personally, or the business itself, has filed bankruptcy and if the first or second notes were included in that bankruptcy.

Taxes, Insurance, Liens: Commercial first mortgages are less likely to escrow tax and insurance payments along with principal and interest and are more likely to leave that responsibility with the property owner. The first mortgage may or may not actively monitor for other liens against the property.

We bought a note that was two years behind on taxes, and there was nothing on public record showing the first mortgage was doing anything about it. We insisted the seller convince the borrower to bring their taxes current. The borrower brought only one year of taxes current, so we lowered our purchase price in exchange for taking on this problem ourselves.

Difficult Valuation: Even if you can find a commercial property listed on Zillow, their valuation is likely to be very wrong. You can use the tax value, but in many counties the assessor’s value differs considerably from market value. Unlike residential properties whose value is primarily determined by the values of comparable nearby properties, commercial property value is determined much more by income. It may be very difficult for you to learn exactly how much rent is coming in. A commercial Broker’s Price Opinion (BPO) can take weeks and cost hundreds of dollars. “There are no bad notes, only bad prices.”

It could be hard to collect rent from a travel agency or video store!

Changing Value: Since value is determined by property revenue, it is determined in part by tenants paying their leases, which is in part determined by the quality of property management. As a note holder, you have almost no say in who the tenants are or how the property is managed. Tenants could stop paying or the manager could under-perform at any time, not only affecting immediate cash flow, but also market value.

Macroeconomic changes can also affect your property value. Small, local retail shops are threatened by online shopping and big box stores. Medical costs continue to increase with no end in sight. These days it could be hard to collect rent from a travel agency or video store!

You can argue with reality if you like. You can make your best effort to change it. Or you can change yourself, open your mind to new ideas, and build your future by adapting. Investing in unknowns requires what my first real estate teacher called intestinal fortitude. Success in the notes space is determined by your ability to make the right decisions about calculated risks with limited information in a short time. You’re not always going to be right. You just need to be right most of the time and have the patience to see your decisions through.

Sándor Lau is the founder of Noted Financial and has been investing in junior notes and speaking at the Paper Source Note Symposium since 2013. His Paper Source presentation videos and many others on how to live richly are all free at YouTube.com/Sándorlau. We would be happy to quote a price for your junior loans secured by residential or commercial real estate. info@notedfinancial.com. NotedNoteBuyers.com.

Investing in residential or commercial junior real estate notes can give tremendous advantages to investors willing to understand them and put in the effort and patience to collect on them. Some of those advantages include:

Discount: Loans usually sell for a discount from the full unpaid principal balance. Junior loans usually sell at an even greater discount. Defaulted junior loans sell at some of the greatest discounts.

Diversification: Larger discounts and smaller loan amounts than first mortgages mean that the price per loan for seconds is typically lower than for firsts. Lower prices allow investors to diversify their portfolios across more assets in more markets, putting more eggs in different baskets.

Appreciation: My dream residential loan is a $50,000 second mortgage on a $500,000 home in an urban or suburban area of a nonjudicial foreclosure state where the borrowers are paying the first mortgage. Assuming uniform appreciation of 5%, that $500,000 house goes up $25,000 a year while a $50,000 home goes up only $2,500 a year.

Principal Paydown: Borrowers paying their first mortgage every month are reducing the principal balance of their loan, increasing the equity securing the second loan. The longer they pay, the more the loan amortizes down and more of their monthly payment goes toward principal.

Property Preservation: Whether or not borrowers are paying their first mortgage, as long as there is a servicer managing the first loan, that servicer is making sure taxes, liens and insurance are being paid. The bank is not going to let their $500,000 collateral get foreclosed on for a $2,000 HOA lien.

Borrower Motivation: Borrowers who are paying their first mortgage are also very likely to have a job or income stream. They pay the first mortgage because they enjoy living there (or collecting rent from their tenants). Their payment history as revealed by their credit report is the quickest way to see their level of motivation. If they have income and like living there, they are likely to be more motivated to want to pay their second mortgage.

I began note investing in the residential second mortgage space, but market prices for second loans, even defaulted ones, are now often higher than I’m comfortable paying. No one wins arguing with reality. You can try to change others, but it’s much easier to change yourself.

Looking for an additional investing niche, I have started investing in commercial second mortgages which afford investors most of the same advantages as residential loans, and a few more.

Commercial Mortgage Advantages

No FDCPA: The Fair Debt Collection Practices Act (FDCPA) governs collection of consumer debt and places severe restrictions and penalties on collectors who break it. I’m not a lawyer, accountant, or pro wrestler. If you want advice in any of those areas, please seek it from a qualified professional, but here’s what the NOLO Legal Encyclopedia says: “The FDCPA only applies to consumer debts incurred for personal or household expenses. It does not apply to corporate or other business debts.”

High-Value Properties: Commercial properties are often more valuable than average homes. If a $5,000,000 apartment complex, medical building, office, shopping center, self-storage facility or mobile home park appreciates 5%, it goes up $50,000.

Income-Generating Properties: Most homeowners only consider one option for generating revenue to pay their obligations — employment. Many homeowners are also perfectly capable of increasing their income by renting out rooms or space on Airbnb or driving for Uber or Lyft if they want to, but many prefer not to.

Investors who own commercial property are already entrepreneurial. That’s why they bought the property in the first place, and if they are motivated, they can probably find a way to increase income from the property.

Bigger Discounts: Very few investors will touch the most plain vanilla second mortgages — residential loans. Even fewer will consider commercial seconds. You may have heard of the law of supply and demand.

Shorter Terms: Lending money is inherently risky because the borrower gets what they want up front and all at once in exchange for a promise to consistently make their payment every month in the future. Every month is a new risk in that the borrower may break their promise. Whereas a typical home mortgage fully amortizes over 30 years, a typical commercial loan has a balloon in five or 10 years.

You can increase your returns by increasing the velocity of your money, buying at a discount and getting a full payoff in the shortest time possible. Most commercial loans also amortize on a shorter schedule, meaning the proportion of the first mortgage payment going to principal starts higher and increases faster than in most 30-year residential loans.

Rational Borrowers: Most people make the majority of their decisions based on their emotions rather than logic. And many homeowners decide whether to pay their debts based on whether it makes them feel good. Business owners are more likely to be more rational and acknowledge their responsibility to pay their debts.

Next month: The unique challenges of second loans on commercial property.

Sándor Lau is the founder of Noted Financial and has been investing in junior notes and speaking at the Paper Source Note Symposium since 2013. His Paper Source presentation videos and many others on how to live richly are all free at YouTube.com/Sándorlau. We would be happy to quote a price for your junior loans secured by residential or commercial real estate. info@notedfinancial.com. NotedNoteBuyers.com.

After presentations end, join Sándor hiking in Red Rock Canyon to invest in your health and cash in on fun, just a short drive from Las Vegas. Spots are limited and you must register in advance. Learn more and sign up here.

Sándor has been a regular speaker at the Paper Source Note Symposium in Las Vegas since 2014, educating participants on how to achieve success in note investing. His 2016 presentation revealed new case studies, how he slept on the floor at the office for over a year so he could rent his home out on Airbnb to pay his own mortgage while getting started in note investing, and how the market is changing. Watch it on YouTube.